bond etf vs bond fund

Bond ETFs Vs. Bond Mutual Funds: Which Should You Choose?

Bond ETFs are cheaper, more tradable and more transparent than bond mutual funds. They’re even a better deal in stressed, illiquid markets.

At first glance, there doesn't seem to be much difference between bond mutual funds and bond ETFs. Like mutual funds, bond ETFs roll up hundreds, even thousands, of bonds into a single portfolio at a purchase price significantly less than what it would be to invest in each bond individually. Also like mutual funds, bond ETFs pay regular dividends to investors. And ETFs as well as mutual funds come in a variety of flavors, from Treasurys to municipal bonds, to suit every investor's risk tolerance and income needs.

But look more closely, and you'll see the similarities between the two only run skin deep.

A bond ETF offers bonds in a stocklike wrapper. Though these investment vehicles hold bonds and only bonds, they trade on exchanges like stocks. With ETFs, therefore, investors can get the safety of bonds with the flexibility exchange-trading can provide.

Bond ETFs Cheaper, Tradable

Bond ETFs offer several advantages over mutual funds, including:

Tradability: You can buy and sell ETF shares at any time during the trading day, even in segments of the bond market where individual issues might trade much less frequently. You can also buy bond ETFs on margin and sell them short, allowing for a greater range of investment strategies. Mutual funds, meanwhile, are only traded once a day after market hours, and you can neither buy mutual funds on margin nor sell them short.

Transparency: Exchange trading makes ETFs more transparent than mutual funds, and most ETF managers publish a complete listing of their holdings daily. Managers often only publish mutual fund holdings once a quarter.

Lower total costs: Bond ETFs tend to be cheaper than their mutual funds. Why? Because there is less work involved in running an ETF. As detailed in “ETFs Vs. Mutual Funds: Which Is Right for You?”, the ETF system saves on paperwork, record-keeping, distribution costs and more. The end result? An ETF's total expense ratio is usually lower than that of a comparable mutual fund.

Bond ETF Investors Pay Commissions, Spreads

Bond ETFs aren't without their drawbacks, however.

Commissions: Every time you buy and sell shares of an ETF, you incur a trading commission. If you regularly invest small amounts of money, such as through regular paycheck contributions to a retirement account, those commissions can quickly add up. Although several commission-free ETF trading platforms have emerged in recent years, you should still check your brokerage's rules before investing.

Bid/Ask Spreads: Like stocks, an ETF's spread is the difference between the price you pay to acquire a security and the price at which you can sell it. You buy the spread whenever you trade an ETF; it's unavoidable. In the bond market, these spreads can become pretty wide, especially sectors that are already thinly traded or illiquid.

Premiums/discounts: When you buy or sell a mutual fund, you always transact exactly at the fund's stated net asset value (NAV). ETF prices, however, are influenced by share supply and demand. Though mechanisms exist to keep ETF share prices in line with NAV, they're not always perfect, and sometimes an ETF may trade at high premiums or discounts to NAV.

Mutual fund devotees often point out that during times of market distress, bond ETFs may trade with large premiums and discounts. It's true, but that doesn’t mean bond mutual funds are better. In fact, unless you're a panic seller, during volatile times, bond mutual fund investors may be worse off. (See: “Bond ETFs Vs. Bond Mutual Funds: Which Should You Choose?”)

Individual bond values are hard to calculate. Without an official exchange, there's no single agreed-upon price for the value of any particular bond. In fact, many bonds don't even trade daily; certain types of municipal bonds, for example, can go weeks or even months between trades.

Fund managers need accurate bond prices to calculate NAV. Mutual fund and ETF managers rely on bond pricing services, which estimate the value of individual bonds based on reported trades, trading desk surveys, matrix models and so on. It's not a sure thing, of course. But it's a good guess.

An ETF’s share price isn’t exactly its NAV. Unlike a mutual fund, whose share price is always its NAV, an ETF's share price may drift from its NAV due to market supply and demand. Premiums develop when prices rise above NAV, and discounts develop when prices fall below NAV. But there's a natural mechanism in place to keep an ETF’s share price and NAV aligned: arbitrage.

APs use arbitrage to keep ETF share prices and NAV in line. A special class of institutional investors known as "authorized participants" (APs) have the ability to create or destroy shares of an ETF at any time. Should an ETF's share price dip below its NAV, APs can make money on the difference by buying up shares of the ETF on the open market and trading them in to the issuer for an "in kind" exchange of the underlying bonds. To profit, the AP simply needs to liquidate those bonds. Likewise, if an ETF's share price rises above NAV, APs can buy up the individual bonds and trade them in for ETF shares. Arbitrage creates a natural buying or selling pressure that tends to keep an ETF's share price and NAV from drifting too far from each other.

In stressed or illiquid markets, an ETF's price may be below its reported NAV by a lot, or for a long period of time. When that happens, it essentially means APs and market makers think the bond pricing service is wrong, and that they’re overestimating prices for the fund's underlying bonds. In other words, the APs don't believe they can actually liquidate the underlying bonds for their reported values. For ETF investors, this means the ETF price falls to a discount to its NAV. (The reverse is true for any premiums that may arise.)

Bond mutual funds guarantee the ability to buy and sell exactly at NAV in times of market stress. That's a good thing. Buying and selling exactly at NAV shields shareholders who want to exit during times of market stress from the true costs of liquidating that portfolio. But what about the shareholders who don't sell?

Buy-and-hold bond mutual fund investors subsidize the costs of investors who leave. To fill a redemption request, mutual fund managers must give the exiting investor cash equal in value to NAV. In normal markets, the fund would just sell bonds to come up with the cash. But in stressed markets, that's harder to pull off. As the APs have already discovered, it’s not possible to sell the underlying bonds for the prices, given by the pricing service. Therefore, mutual funds often have to sell more bonds than the NAV's worth to make up the difference. The shareholders who stay are the ones to absorb that cost. Plus, because funds process redemptions overnight, funds must keep cash on hand—creating cash drag on returns — or maintain a credit facility, which shows up as a fund expense. Thus, buy-and-hold bond mutual fund investors are often penalized for staying in their fund during periods of market stress.

Bond ETFs Vs. Bond Mutual Funds: Making The Choice

Whether a bond ETF or a mutual fund is right for you depends on your goals, of course, but also on your philosophy.

If you believe in the power of active management, then there's likely a mutual fund option with your name on it. Active bond funds remain a relatively new idea in the ETF space, and while some big-name managers troll the ETF waters, the choices pale in comparison to those found in mutual fund land.

If, however, you want lower fees, intraday tradability and the ability to know what you own at all times, then a bond ETF is for you. Furthermore, in stressed or illiquid markets, you aren't penalized for staying in a bond ETF when other investors might leave.

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Pros & Cons Of Bond Funds Vs. Bond ETFs

Building a diversified bond portfolio is a time-consuming task that requires an amount of money that is beyond the means of many investors. Fortunately, mutual funds and exchange-traded funds (ETFs) offer convenient alternatives. Understanding the pros and cons of each will help you choose the one that is right for you.

Before comparing bond funds and bond ETFs, it is worth taking a few moments to review the reasons why investors buy bonds. Most investors put bonds in a portfolio to generate income. While buying and selling bonds in an effort to generate a profit is a viable strategy, this type of activity is more common among professional investors than among individuals.

Investors also buy bonds for risk-related reasons, as they seek to store their money in an investment that is less volatile that stocks. Before investing in bonds, you should have a clearly defined reason for doing so, as it will help you choose the right investment vehicle. To learn more about bonds, read the BondBasics: Introduction tutorial.

Bond Funds and Bond ETFs

Bond funds and bond ETFs share several characteristics. Both offer diversification via portfolios that hold numerous bonds. Both do so with a significantly smaller minimum required investment than would be necessary to achieve the same level of diversification by purchasing individual bonds and using them to construct a portfolio. Both pay dividends and capital gains on a regularly scheduled basis, which serve as an income stream for investors. Both offer a wide variety of investment choices ranging from high-quality government bonds to low-quality corporate bonds and everything in between. And both can be purchased and sold through a brokerage account in exchange for a small per-trade fee. Despite these similarities, bond funds and bond ETFs also have some unique, unshared characteristics.

Mutual funds have been investing in bonds for a long time. Some of the oldest balanced funds (which include allocations to both stock and bonds) date back to the late 1920s. Accordingly, there are a large number of bond funds in existence offering a significant variety of investment options. These include both index funds, which seek to replicate various benchmarks and make no effort to outperform those benchmarks, and actively managed funds, which seek to beat their benchmarks. Actively managed funds also employ credit analysts to conduct research into the credit quality of the bonds the fund purchases in an effort to minimize the risk of purchasing bonds that are likely to default.

Bond funds are available in two different structures: open-ended funds and closed-end funds. Open-ended funds can be bought directly from fund providers, which means that they do not need to be purchased through a brokerage account. If purchased directly, the brokerage commission fee can be avoided. Similarly, bond funds can be sold back to the fund company that issued the shares, making them highly liquid.

In addition, open-ended funds are priced and traded once a day, after the market closes and each fund’s net asset value (NAV) is determined. The trading price is a direct reflection of the NAV, which is based on the value of the bonds in the portfolio. Open-ended funds do not trade at a premium or a discount, making it easy and predictable to determine precisely how much a fund’s shares will generate if sold. Notably, some bond funds charge an extra fee if they are sold prior to a certain minimum required holding period (often 90 days), as the fund company wishes to minimize the expenses associated with frequent trading.

Interestingly, bond funds do not reveal their underlying holdings on a daily basis. They generally release holdings on a semi-annual basis, with some funds reporting monthly. This lack of transparency makes it difficult for investors to determine the precise composition of their portfolios at any given time.

Bond ETFs are a far newer entrant to the market, with iShares launching the first one in 2002. Most of these offerings seek to replicate various bond indices, although a slowly growing number of actively managed products are coming to market. The launch of an ETF that seeks to replicate PIMCO’s famous Total Return Bond (BOND) was a noteworthy development that could lead other fund companies to launch similar ETFs designed to replicated popular funds. ETFs often have lower fees than their mutual fund counterparts, potentially making them the more attractive choice to some investors if the identical strategy is available as either an ETF or an open-ended mutual fund.

Bond ETFs operate much like closed-end funds, in that they are purchased through a brokerage account rather than directly from a fund company. Likewise, when an investor wishes to sell, ETFs must be traded on the open market—meaning that a buyer must be found because the fund company will not purchase the shares as they would for open-ended mutual funds.

Like stocks, ETFs trade throughout the day. The prices for shares can fluctuate moment by moment and may vary quite a bit over the course of trading. Extremes in price fluctuation have been seen during market anomalies, such as the so-called Flash Crash. Shares can also trade at a premium or a discount to the underlying net asset value of the holdings. While significant deviations in value are relatively infrequent, they are not unheard of. Deviations may be of particular concern during crisis periods, for example, if a large number of investors are seeking to sell bonds. In such events, an ETF price may reflect a discount to NAV because the ETF provider is not certain that existing holdings could be sold at their current stated net asset value.

Bond ETFs do not have a minimum required holding period, meaning that there is no penalty imposed for selling rapidly after making a purchase. They can also be bought on margin and sold short, offering significantly greater flexibility in terms of trading than open-ended mutual funds. Also, bond ETFs reveal their underlying holdings on a daily basis, giving investors complete transparency. For more information, see A Guide For Buying ETFs On Margin and Short Selling: Introduction.

The decision over whether to purchase a bond fund or a bond ETF is less about which investment vehicle is better or worse and more about what your needs and objectives are as an investor. If you want active management, bond mutual funds offer more choices. If you plan to buy and sell frequently, bond ETFs enable you do to so. If you are a long-term, buy-and-hold investor, bond mutual funds meet your needs.

If knowing exactly what you hold at any given moment is important to you, bond ETFs provide the required transparency. If you take comfort in the ability to sell your holdings back to the issuer on any given day, bond funds offer that security.

Ultimately, both vehicles provide access to the bond markets. Both offer diversified portfolios. Both offer a convenient way to build a portfolio. The choice of one over the other is likely to be based more on personal preference or specific investment need rather than superiority/inferiority in terms of bond market exposure or portfolio diversification. As with most investment decisions, the first move you make should involve learning as much as you can about the investment you are considering. When you understand what you are about to buy and why you are buying, you have a better chance of making a wise decision.

In order to choose whether to invest in bonds or bond funds, itвЂ™s important to understand the key differences between the two, along with the benefits and risks involved.

Different approaches and risks

Bonds are individual fixed income securities with fixed yields and maturity dates. In contrast, bond funds donвЂ™t have fixed yields or fixed maturity dates. This is because bond funds invest in a variety of individual bonds, which are collectively designed to provide potential income continuity to the fund. Investors are paid based on the overall income and return of this portfolio of bonds and not by individual bond maturity. Put another way, this means a mutual fund or exchange-traded fund consisting entirely of bonds is, in fact, not a fixed income asset, but rather a portfolio of bonds that trades as an individual security.

With individual bonds, the risk level depends on the bondвЂ™s characteristics like the credit worthiness of the issuer. The credit worthiness of public and corporate bond issuers, for example, is rated by major agencies on a scale ranging from AAA (вЂњHighest QualityвЂќ) to D (вЂњIn defaultвЂќ).

Visit E*TRADEвЂ™s Bond Resource Center to screen for bonds, get the latest bond news, and more (logon required).

The risk profile of bond funds is, in contrast, often in a state of flux because fund managers regularly trade positions. ItвЂ™s essential, however, to familiarize yourself with the fund management strategy and its approaches to risk prior to investing.В

What to ask yourself before investing

There are four questions investors might ask when considering whether to invest in bonds or bond funds.

1. Do I want to take control or do I want a professional to manage my bond investments?

A professional fund manager can monitor and rebalance an actively managed bond fund as necessary, regularly realigning the portfolio with its stated goals. For some investors, this active management strategy is an attractive feature of bond funds, but it typically comes at the cost of management and other fees defined by the fundвЂ™s expense ratio.

Investors who prefer to conduct their own research and build a portfolio of individual bonds can forgo these management fees, but may be subject to commission or markup/markdown on individual bond purchases.

2. How much do I plan to invest? Do I want to diversify cheaply?

ItвЂ™s worth noting that different types of individual bonds like Treasury, municipal, and corporate, require varying minimum investments. The cost of entry may be up to several thousand dollars depending on the bond you choose. And to be well diversified you may need to buy a large number of different bonds.

With bond funds, on the other hand, youвЂ™ll need to research the fund to determine whether your goals align with the fundвЂ™s stated objective and if you are comfortable with the minimum investment levels. If you are, bond funds may offer a more direct and cost-effective path to diversification.В

3. WhatвЂ™s my risk appetite?

There are pros and cons associated with investing in different types of bonds. For instance, corporate bonds can pose higher risk than municipal and Treasury bonds. But higher risk bonds may also offer the potential for higher returns.В

With bond funds, choose a strategy that reflects how comfortable you are with different levels of risk. Remember, your risk may be at least somewhat offset by the diversification built into a fund portfolio.

4. Do I prefer a regular fixed income stream or am I okay with fluctuating payments?

ThereвЂ™s a trade-off between convenience and risk here.

Individual bonds typically pay investors on an annual or a semi-annual basis. If you prefer more frequent payouts, you may need to structure your portfolio accordingly, typically by purchasing a number of different bonds with staggered interest payment dates.

Bond funds tend to pay out to investors more frequently than individual bonds. Most bond funds pay investors on a monthly basis. This could potentially offer investors a monthly income stream at a lower investment expense. Payment amounts can fluctuate much more with bond funds, however, as the fund managers trade positions.В

Understanding these key differences between bonds and bond funds are an important step in determining which may be appropriate for your particular situation.

If you have any questions about bonds in general or how to get started investing in bonds, please call us at 1-866-420-0007 to talk with an E*TRADE Fixed Income Specialist, or visitE*TRADEвЂ™s Fixed Income Solutions Center (logon required).

Once you’ve decided that you want to allocate a portion of your portfolio to bonds, you’ll need to decide how exactly you want to buy and own those bonds. You have two primary options: Buy individual bonds or purchase a mutual fund that invests in bonds.

There’s no definitive right or wrong answer here; each option has its pros and cons. In some cases, it makes the most sense to combine individual bonds with bond mutual funds. A right choice for you depends on your ability and interest in researching your initial investments, your willingness to track them on an ongoing basis, the amount of money you have to invest, and your tolerance for different types of risk.

A distinguishing feature of individual bonds is their commitment to pay out a defined amount of income at regular intervals, usually twice a year. This income is generally expressed through the coupon—which in most cases is fixed. The bond’s principal is returned to you when the bonds mature.

Another key differentiator of individual bonds is that they give you the ability to buy into a fixed rate of return, or “yield” at the time of purchase. By calculating the future cash flows—based on the bond’s coupon and principal— as a function of the purchase price, it is possible to derive a total return or yield to maturity—or yield to call in the case of callable bonds. This yield is the annual return on your initial investment through some predetermined future date. Remember, achieving this calculated yield rests on two important assumptions:

a) You hold the bond until it either matures or is called.

b) The issuer does not default so that you receive all interest payments and your principal.

Note that interest and principal payments are subject to the issuer’s creditworthiness and a higher quoted yield frequently implies a higher risk of the bond defaulting and thus not delivering on its promised cash flow and yield.

As an investor, it’s important to remember that while investing in individual bonds and holding them until maturity or the call date enables you to effectively manage interest rate or market risk, it does heighten the importance of scrutinizing credit risk of each individual issuer while carefully assessing your own liquidity needs.

You can sell individual bonds before the maturity date, although certain bond types that trade in more liquid markets—such as Treasuries and certain corporate bonds—may be easier to sell than most municipal bonds, where markets are thinner and less liquid. Selling before maturity can result in either a profit or a loss, depending on the price you paid for the bonds, the amount of interest you’ve already collected, the current interest rate environment, and the current price of the bonds.

Investing in individual bonds will require sufficient funds to enable you to diversify across several different issuers to ensure a reasonable amount of diversification. Generally speaking, investing in a diversified portfolio of bonds requires at least $100,000–$200,000, depending on the type of bonds chosen and their credit risks. You don’t want to put all your money into a single bond, since there is a risk of default even on high quality bonds. If you’re only buying Treasury bonds or CDs, which have historically been the safest fixed income investment available, you can invest far less without having to diversify quite as much.

Buying individual bonds also means you’re responsible for researching and monitoring the financial stability of the issuer, determining if the bond price is reasonable and building a portfolio around your need for income, risk tolerance and general diversification. Fidelity can help you do this, through our Fixed Income Research Center and Monitoring Alerts.

For many investors, though, a bond fund may be a better approach.

Bond mutual funds are just like stock mutual funds in that you put your money into a pool with other investors, and a professional invests that pool of money according to what he or she thinks the best opportunities are, in accordance with the fund’s stated investment goals. Some bond funds seek to mimic the broad market, investing in short- and long-term bonds from a variety of issuers, such as the U.S. government, government agencies, corporations, and other more specialized securities. Other bond funds focus on a narrower mix of bonds, such as a short-term Treasury fund or a corporate high yield fund.

Whether the fund’s mandate is broad or narrow, bond funds invest in many different securities, so it’s an easier way to achieve diversification even with a small investment. Income payments are made monthly, and reflect the mix of all the different bonds in the fund and the payment schedule of each. As such, the distribution may vary from month to month.

When you sell shares in a fund, you receive the fund’s current net asset value (NAV), which is the value of all the fund’s holdings divided by the number of fund shares, less any redemption fee, if applicable. It’s important to remember that bond funds buy and sell securities frequently, and rarely hold bonds to maturity. That means you can lose some or all of your initial investment in a bond fund.

Bond ETFs are easily available on stock exchanges today. Bond mutual funds have been around for a long time.

I am not sure which to buy to build an income stream as a fixed-income investor. What are the pros and cons of bond ETFs versus bond mutual funds?

Bond ETFs are just another way to buy a bond mutual fund. An ETF lets you trade mutual fund shares the way you trade stocks, in small share-size increments. The content of this answer applies equally to both stock and bond funds.

If you are intending to buy and hold these securities, your main concerns should be purchase fees and expense ratios. Different brokerages will charge you different amounts to purchase these securities. Some brokerages have their own mutual funds for which they charge no trading fees, but they charge trading fees for ETFs. Brokerage A will let you buy Brokerage A's mutual funds for no trading fee but will charge a fee if you purchase Brokerage B's mutual fund in your Brokerage A account.

Some brokerages have multiple classes of the same mutual fund. For example, Vanguard for many of its mutual funds has an Investor class (minimum $3,000 initial investment), Admiral class (minimum $10,000 initial investment), and an ETF (share price as initial investment). Investor class has the highest expense ratio (ER). Admiral class and the ETF generally have much lower ER, usually the same number. For example, Vanguard's Total Bond Market Index mutual fund has Investor class (symbol VBMFX) with 0.16% ER, Admiral (symbol VBTLX) with 0.06% ER, and ETF (symbol BND) with 0.06% ER (same as Admiral). See Vanguard ETF/mutual fund comparison page. Note that you can initially buy Investor class shares with Vanguard and Vanguard will automatically convert them to the lower-ER Admiral class shares when your investment has grown to the Admiral threshold.

Choosing your broker and your funds may end up being more important than choosing the form of mutual fund versus ETF. Some brokers charge very high purchase/redemption fees for mutual funds. Many brokers have no ETFs that they will trade for free. Between funds, index funds are passively managed and are just designed to track a certain index; they have lower ERs. Actively managed funds are run by managers who try to beat the market; they have higher ERs and tend to actually fall below the performance of index funds, a double whammy.